Proceedings of International Business and Social Sciences and Research Conference
16 - 17 December 2013, Hotel Mariiott Casamagna, Cancun, Mexico, ISBN: 978-1-922069-38-2
Assessing the Impact of Interest Rates on Money Demand in Different
States of the Economy
Dr. Meng Li
Central banks around the world are implementing monetary policy by targeting a very low
short-term interest to stimulate the aggregate demand. During the recent financial crisis,
the Fed increased monetary base by more than 200% through targeting the Federal Fund
Rate at 0-1/4 percent range, the M1 money demand only rose by less than 25%. Does
monetary policy become impotent to affect the economy? How do we explain the
occurrence of the liquidity trap, where money demand does not respond to the lowered
interest rate?
This paper attempts to improve our understanding about the observed liquidity trap by
analyzing both the long term and short term relationship between interest rates and money
demand. Consistent with the Keynesian liquidity preference theory of money demand
(1936), our cointegration analysis using US data from 1966Q1 to 2011Q1 reveals a long
run negative correction between interest rates and money demand.
In the test for short term relationship, the paper finds that the dynamic response of money
demand to interest rate shocks varies with the state of economy. The state of economy is
assigned to be either expansion or contraction based on increase or decrease of GDP
measurement. The first difference estimation shows that the negative correlation between
interest rates shocks and demand for money exists only when GDP grows, and the
significant link disappears when GDP declines. This result therefore provides partial
explanation for the ineffectiveness of monetary policy during current financial crisis.
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Dr. Meng Li, Finance, Roosevelt University, 430 S. Michigan Ave, Chicago, U.S.A.